Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company’s legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million. Contingent assets are assets that are likely to materialize if certain events arise.
- As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown.
- Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence.
- However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.
- The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.
Some examples of such liabilities would be product warranties, lawsuits, bank guarantees, and changes in government policies. Contingent liabilities can pose a threat to the reduction of net profitability and company assets. This means that they can potentially negatively impact the health and financial performance of a company. Ultimately, this is why these situations or circumstances must get disclosed in the financial statements of a company.
IAS plus
Under US GAAP, the
low end of the range would be accrued, and the range disclosed. Another way to establish the warranty liability could be an
estimation of honored warranties as a percentage of sales. In this
instance, Sierra could estimate warranty claims at 10% of its
soccer goal sales. Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms.
- Do not record or disclose a contingent liability if the probability of its occurrence is remote.
- Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes.
- If the contingent liability is considered
remote, it is unlikely to occur and may or may not
be estimable. - These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated.
Generally, a ‘remote’ likelihood ranges between 5% and 10%, though IAS 37 doesn’t explicitly specify this. IAS 37.86 details the disclosure requirements, emphasising that any contingent liability with an outflow possibility exceeding ‘remote’ should be disclosed. A loss contingency which is possible but not probable will not be recorded in the accounts as a liability and a loss.
However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred. If the recognition criteria for a contingent liability are met, entities should accrue an estimated loss with a charge to income. If the amount of the loss is a range, the amount that appears to be a better estimate within that range should be accrued. If no amount within the range is a better estimate, the minimum amount within the range should be accrued, even though the minimum amount may not represent the ultimate settlement amount.
Business leaders should also be aware of contingent liabilities, because they should be considered when making strategic decisions about a company’s future. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be control account definition listed on the balance sheet as a liability. Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information.
FAQs About Contingent Liability
The full disclosure principle requires that any relevant and significant facts that are related to financial performance must be disclosed in the company’s financial statements. Within this principle, referring to the term material also refers to the liability being significant. Since some contingent liabilities can have a negative impact on the financial performance and health of a company, having knowledge of it can influence decision-making when it comes to financial statements. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements.
On the Radar: Accounting for contingencies and loss recoveries
In such instances, the ‘virtually certain’ threshold is applicable before a disputed asset can be recognised. Essentially, the effect that contingent liabilities have on an audit depends on their likelihood of occurring in the first place. As well, the impact on financial statements depends on the likelihood of the contingency occurring and the total amount of the transaction. Some of the best contingent liability examples include warranties and pending lawsuits. Warranty liability is considered to be a contingent liability since it’s often unknown how many products could be returned under a warranty.
Do not confuse these “firm specific” contingent liabilities with general business risks. General business risks include the risk of war, storms, and the like that are presumed to be an unfortunate part of life for which no specific accounting can be made in advance. The determination of whether a contingency is probable is based
on the judgment of auditors and management in both situations. This
means a contingent situation such as a lawsuit might be accrued
under IFRS but not accrued under US GAAP. Finally, how a loss
contingency is measured varies between the two options as well.
For example, investors might determine that a company is financially stable enough to absorb potential losses from a contingent liability and still decide to invest in it. But a contingent liability needs to be large enough to be able to truly affect a company’s share price. The International Financial Reporting Standards (IFRS) and GAAP outline certain requirements for companies to record all of their contingent liabilities. Usually, the contingent liability will be outlined and disclosed in a footnote on the financial statement.
IFRS Accounting
On the Radar briefly summarizes emerging issues and trends related to the accounting and financial reporting topics addressed in our Roadmaps. The ‘not-to-prejudice‘ exemption in IAS 37.92 also extends to contingent assets. Additionally, see the forum’s discussion regarding a scenario where a once-recognised contingent asset’s likelihood of resource inflow is no longer virtually certain. Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.
If the estimated loss can only be defined as a range of outcomes, the U.S. approach generally results in recording the low end of the range. International accounting standards focus on recording a liability at the midpoint of the estimated unfavorable outcomes. An example of determining a warranty liability based on a
percentage of sales follows. The sales price per soccer goal is
$1,200, and Sierra Sports believes 10% of sales will result in
honored warranties. The company would record this warranty
liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty
Expense accounts. Since this condition does not meet the requirement of
likelihood, it should not be journalized or financially represented
within the financial statements.
Probable and Not Estimable
A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business.
The flowchart below provides an overview of the recognition criteria, taking into account information about subsequent events. Contingent liabilities adversely impact a company’s assets and net profitability. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely. A contingent liability is recorded in the accounting records if the contingency is probable and the related amount can be estimated with a reasonable level of accuracy.